Investment Banking: The New Frontier for Real Estate Operators

March 16, 2017

Many people are drawn to real estate investing because it allows them to play an active role in determining the success of their investments. For others, real estate investing represents a unique career opportunity to dramatically improve their entire lives. This opportunity lies in real estate’s unique ability to be leveraged… whether through traditional bank mortgages or by more creative means such as lease-options, subject-to purchases and seller carrybacks. More astute real estate investors, or operators, take leverage to the next level with a foray into borrowing from private lenders or even recruiting an equity partner or two. When an operator uses the money of others, via debt or equity, who do not actively participate in his business in exchange for the promise of a return on investment, he has entered the capital markets by issuing securities (and yes, a mortgage loan against an investment property is considered a security). As the name suggests, capital markets are simply the markets for capital, or money; people who hold money, or savers, have to put it somewhere, and just like at your local grocery store, savers look for the highest quality products at the lowest prices. Generally speaking as applied to the capital markets, quality corresponds to risk while price corresponds to returns. Some investors have a higher risk tolerance in exchange for the expectation of higher returns and may not need to cash out, or liquidate, for a fairly long period of time… maybe decades. Others, like retirees, typically have a lower tolerance for risk, as their savings is not easily replaceable, and they need to generate cash, or liquidity, immediately on a monthly or quarterly basis to cover the expenses of their retirement years. Of course, there are any number a variations of risk, return, and liquidity appetites in between, but at the end of the day, these are the only three meaningful considerations in deciding how to invest. Everything else is just a distraction.

From the use of sophisticated sounding jargon to tell fanciful stories about the future, to the veneer of nice suits and high-rise offices, the traditional financial industry specializes in marketing such distractions to capture the over 17 trillion dollars in savings held by U.S. workers. Ultimately, Wall Street operates in the very same way that a casino does: it strategically facilitates the creation of gambling opportunities via securities for customers to wager their money at some well-calculated probability. The biggest difference between a casino and professional finance is that the probabilities associated with investing are much more complex and easier to hide; but like a casino, financial institutions ensure the house always wins by stacking the odds eternally in their favor (it’s also why physicists and mathematicians who are driven by money move to Wall Street). To make the point more obviously, sound investment decisions boil down to nothing more than numbers (assuming you can trust those numbers, which is the purpose of financial audits): expected net return (some percentage), associated risk (also a percentage), and liquidity, or the amount of time your money is locked up (expressed as some unit of time: days, months, years, etc.). So, how are these numbers calculated? That is the 17 trillion dollar question, and the answer to that question is the fundamental tool of the financial wardens… the firms that underwrite and make the market for securities: investment banks.

Investment banks are intermediaries that, amongst many other functions, help typically large companies raise capital by advising on and underwriting new securities issues. To prepare for a new issue of securities, investment banks first advise their clients on considerations such as capital structure (how much debt vs. equity should be issued; what types of equity and debt should be issued, etc.), the strategic use of other financial instruments (such as warrants), and operational considerations as a means to ensure its success. Once offerings are constructed, investment banks underwrite the securities that are being issued. Underwriting means that investment banks price securities offerings, then guarantee their pricing by typically purchasing the offerings before reselling them to the public at a markup. So as you can imagine, investment bankers are very keen on developing a thorough and meaningful understanding of how to price risk, even if they don’t communicate all the nuances to the public through their distribution channels (i.e. financial advisers).

Moving back into the realm of private real estate, the investment banking function is badly needed as real estate operators, regardless of size, typically have no idea how to structure models and price offerings in a manner that can compete with the sophistication of their rivals: private equity and hedge funds. As a result, private real estate operators are dismissed by the financial industry, which impedes their access to the capital markets in a classic example of the Chicken and Egg Problem. The closest thing private real estate operators have to third-party capital raising support is crowdfunding, where financial sales people who charge disproportionately high fees check a few boxes to meet their regulatory obligation before stating that the operators on their platform are legitimate… the investing public then herds into their internet portals in a glorious example of the blind leading the blind. (If you don’t believe me, just ask the broker-dealer representative of a crowdfunding platform what the risk-adjusted returns of a given issue are; these concepts are hardly covered on the FINRA exams as such licenses are designed to simply credential financial pushers.) This ticking time bomb exposes the investing public to unknown risk and perpetuates Wall Street’s debilitating view of real estate as the red-headed step child of asset classes: even the best of operators are simply riding market cycles.

So herein lies the problem and the opportunity… many people sense it, but they can’t put a finger on this key idea: residential income (not market cap rates) experiences less volatility, or random price movement, than any other asset class’s fundamental valuation metric, which means residential real estate securities, when properly structured and managed, offer the potential to generate the best risk-adjusted returns amongst all asset classes regardless of market cycles… from Apple stock and U.S. Treasury bonds to long/short hedge funds. The ability to translate this idea into numbers (i.e. α) is the ability to move real estate from the fringes of the investing world and into mainstream finance. Why should real estate investors care? Because when you, as a private real estate operator, can offer savers verifiably better risk-adjusted returns than the other options they have to choose from (such as stocks, bonds and DIY real estate investing), you can then capture a significant portion of their money for your business: I’m not talking about hundreds of thousands of dollars; I’m talking about hundreds of millions…